Stock Analysis And Everything

Support and resistance exist because masses of traders feel pain and regret. Traders who hold losing positions feel intense pain. Losers are determined to get out as soon as the market gives them another chance. Traders who missed an opportunity feel regret and also wait for the market to give them a second chance. Feelings of pain and regret are mild in trading ranges where swings are small and losers do not get hurt too badly. Breakouts from trading ranges create intense pain and regret.

When the market stays flat for a while, traders get used to buying at the lower edge of the range and shorting at the upper edge. In uptrends, bears who sold short feel pain and bulls feel regret that they did not buy more. Both feel determined to buy if the market gives them a second chance. The pain of bears and regret of bulls make them ready to buy, creating support during reactions in an uptrend.

Resistance is an area where bulls feel pain, bears feel regret, and both are ready to sell. When prices break down from a trading range, bulls who bought feel pain, feel trapped, and wait for a rally to let them get out even. Bears regret that they have not shorted more and wait for a rally to give them a second chance to sell short. Bulls7 pain and bears7 regret create resistance-a ceiling above the market in downtrends. The strength of support and resistance depends on the strength of feelings among masses of traders.

Strength of Support and Resistance

A congestion area that has been hit by several trends is like a cratered battlefield. Its defenders have plenty of cover, and an attacking force is likely to slow down. The longer prices stay in a congestion zone, the stronger the emotional commitment of bulls and bears to that area. When prices approach that zone from above, it serves as support. When prices rally into it from below, it acts as resistance. A congestion area can reverse its role and serve as either support or resistance.

The strength of every support or resistance zone depends on three factors:

Its length, its height, and the volume of trading that has taken place in it. You can visualize these factors as the length, the width, and the depth of a congestion zone. The longer a support or resistance area - its length of time or the number of hits it took-the stronger it is. Support and resistance, like good wine, become better with age. A 2-week trading range provides only minimal support or resistance, a 2-month range gives people time to become used to it and creates intermediate support or resistance, while a 2-year range becomes accepted as a standard of value and offers major support or resistance. As support and resistance levels grow old, they gradually become weaker. Losers keep washing out of the markets, replaced by newcomers who do not have the same emotional commitment to old price levels. People who lost money only recently remember full well what happened to them. They are probably still in the market, feeling pain and regret, trying to get even. People who made bad decisions several years ago are probably out of the markets and their memories matter less.

The strength of support and resistance increases each time that area is hit. When traders see that prices have reversed at a certain level, they tend to bet on a reversal the next time prices reach that level. The taller the support and resistance zone, the stronger it is. A tall congestion zone is like a tall fence around a property. A congestion zone whose height equals 1 percent of current market value (four points in the case of the S&P 500 at 400) provides only minor support or resistance. A congestion zone that is 3 percent tall provides intermediate support or resistance, and a congestion zone that is 7 percent tall or higher can grind down a major trend.

The greater the volume of trading in a support and resistance zone, the stronger it is. High volume in a congestion area shows active involvement by traders - a sign of strong emotional commitment. Low volume shows that traders have little interest in transacting at that level - a sign of weak support or resistance.

1. Whenever the trend you are riding approaches support or resistance, tighten your .protective stop. A protective stop is an order to sell below the market when you are long or to cover shorts above the market when you are short. This stop protects you from getting badly hurt by an adverse market move. A trend reveals its health by how it acts when it hits support or resistance. If it is strong enough to penetrate that zone, it accelerates, and your tight stop is not touched. If a trend bounces away from support or resistance, it reveals its weakness. In that case, your tight stop salvages a good chunk of profits.

2. Support and resistance are more important on long-term charts than on short-term charts. Weekly charts are more important than dailies. A good trader keeps an eye on several timeframes and defers to the longer one. If the weekly trend is sailing through a clear zone, the fact that the daily trend is hitting resistance is less important. When a weekly trend approaches support or resistance, you should be more inclined to act.

3. Support and resistance levels are useful for placing stop-loss and protect-profit orders. The bottom of a congestion area is the bottom line of support. If you buy and place your stop below that level, you give the uptrend plenty of room. More cautious traders buy after an upside breakout and place a stop in the middle of a congestion area. A true upside breakout should not be followed by a pullback into the range, just as a rocket is not supposed to sink back to its launching pad. Reverse this procedure in downtrends.

Many traders avoid placing stops at round numbers. Now, if traders buy copper at 92, they place a stop at 89.75 rather than 90. When they sell a stock short at 76, they place a protective stop at 80.25 rather than 80. These days there are fewer stops at round numbers than at fractional numbers. It is better to place your stops at logical levels, round or not.